Commentaries

PMC Weekly Review - October 20, 2017

The focus on passive investing has surged over the past few years, and investor flows into these index tracking strategies show no signs of slowing. Last week, it was announced that Vanguard is nearing $5 trillion of assets under management (AUM), with nearly $300 billion of index inflows in just the first nine months of this year.1 This now brings Vanguard, who only crossed the $2 trillion level in 2013, much closer to BlackRock, the top-ranked firm by assets and the owner of iShares exchange-traded funds (ETFs), who manages close to $6 trillion. To put these exceptionally large numbers in context: these two asset management firms each control a larger share of assets than the gross domestic product (GDP) of every individual country, with the exception of China and the United States.

Much of the widespread growth of passive investments over the years has come at the expense of active management, which is struggling to retain investors despite an equity market that wants to go only higher. Active managers’ more expensive fees and their recent inability to outperform their stated benchmarks have steered investors into the open arms of passive managers. Earlier this year, a Moody’s report stated that passive investing will likely grow from its current market share of roughly 28.5% of AUM to over half of the total marketplace in four to seven years, but no later than 2024.2 Others believe the shift may occur even faster, as it already is moving at a swift pace. With many already proclaiming the death of active management, let’s dive into what an all-passive world would look like.

In an all-passive world, Wall Street and the investment industry would look very different. The New York Stock Exchange (NYSE) or any other global exchange would serve more as a transaction channel for passive firms to exchange shares. No winners or losers would exist in this market, only shares moving effortlessly from one account to another. Sell and buy side research analysts, whose expertise in picking stocks, speaking with executives, analyzing earnings, and performing channel checks, may no longer be needed. Corporate executives’ and investor relations’ focus would be centered on gaining a larger share of the index weightings or owning newly created indices. The sole driver of market returns would be from flows in and out of passive strategies through forms of program trading. When this selling took place, it likely would be high in momentum. Investors likely would understand the basic nature of their passive investment strategies and own a low-cost product, but would likely have neither the ability to outperform nor to protect in down markets. Wait, down markets? This may be worth considering, as this past week marked the 30th anniversary of the worst one-day stock decline in history for the Dow Jones Industrial Average (DJIA), with much of the blame being placed on program trading and stocks being sold blindly across the board.

The question of what to do in down markets would likely come up in many investor conversations with advisors. One of the greatest benefits of passive investing also may be one of its largest liabilities. Passive management is meant to track an index exactly, never differentiating between good or bad stocks. If company A is going bankrupt, even if everyone knows company A is going bankrupt, but it is part of an index, that index manager must own it. By contrast, active management can and should look to avoid these negative companies. Active management has long pushed its downside protection, but in a market where global central banks have removed much of the overall risk through unprecedented quantitative easing, there hasn’t been much of it to protect.

Although the idea of an all-passive world may be outside the realm of reality, one should not discount passive management’s incredible growth run. At Envestnet | PMC, we often engage clients in the active vs. passive debate, and it is our view that there is room for both of them to coexist. For some clients, an allocation to passive vehicles to gain exposure to large cap core can be blended with active managers in small cap growth, high yield, and a high-quality core bond manager. The investing world has changed a great deal in the thirty years since the Black Monday of October 1987. Passive investment may not rule the world yet, but it certainly has become a large player in an industry that has changed. Investors would be wise to understand the benefits and pitfalls of both active and passive management as they seek the best ways to incorporate them into their portfolio.

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Investments in smaller companies carry greater risk than is customarily associated with larger companies for various reasons such as volatility of earnings and prospects, higher failure rates, and limited markets, product lines or financial resources. Investing overseas involves special risks, including the volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. Income (bond) securities are subject to interest rate risk, which is the risk that debt securities in a portfolio will decline in value because of increases in market interest rates. Exchange Traded Funds (ETFs) are subject to risks similar to those of stocks, such as market risk. Investing in ETFs may bear indirect fees and expenses charged by ETFs in addition to its direct fees and expenses, as well as indirectly bearing the principal risks of those ETFs. ETFs may trade at a discount to their net asset value and are subject to the market fluctuations of their underlying investments. Investing in commodities can be volatile and can suffer from periods of prolonged decline in value and may not be suitable for all investors. Index Performance is presented for illustrative purposes only and does not represent the performance of any specific investment product or portfolio. An investment cannot be made directly into an index.

Alternative Investments may have complex terms and features that are not easily understood and are not suitable for all investors. You should conduct your own due diligence to ensure you understand the features of the product before investing. Alternative investment strategies may employ a variety of hedging techniques and non-traditional instruments such as inverse and leveraged products. Certain hedging techniques include matched combinations that neutralize or offset individual risks such as merger arbitrage, long/short equity, convertible bond arbitrage and fixed-income arbitrage. Leveraged products are those that employ financial derivatives and debt to try to achieve a multiple (for example two or three times) of the return or inverse return of a stated index or benchmark over the course of a single day. Inverse products utilize short selling, derivatives trading, and other leveraged investment techniques, such as futures trading to achieve their objectives, mainly to track the inverse of their benchmarks. As with all investments, there is no assurance that any investment strategies will achieve their objectives or protect against losses.

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